Collusion and Organization Design

This paper investigates how the possibility of collusion between members of an organization affects the choice of organizational design. We consider a moral hazard environment in which a principal chooses the organizational structure before designing contracts. The principal has the choice between a principal–agent organization, where it monitors the output produced by the agent itself, and a principal–supervisor–agent hierarchy, where monitoring is delegated. We identify the conditions under which the possibility of collusion in a principal–supervisor–agent hierarchy entails the superiority of a principal–agent organization. The results suggest that the possibility of collusion may set a limit to the size of organizations.